The time has come to take China into account in all issues related to sustainable human development. It is not only that China possess vast reserves of raw materials needed by industry. Now it is being reported that Chinese high school students are scoring at the top in standard academic tests. So they will have the brainpower to use Chinese resources for Chinese benefits. Hopefully, the Peking government will recognize that no country - not even China - can be self-sufficient in the global age.

China ended its rare earths embargo of the West last week, with
shipments resuming to Japan, the United States, and Europe after a
speech by Secretary of State Clinton raised the diplomatic stakes.
The ban ended as it began, quietly and without official notification.
The question now is whether the resumption of trade will lull the
developed world back into dependence, or whether the whole affair really
was, as Clinton described, a "wake-up call."

In many ways the embargo itself was a sideshow for two larger
disputes—the long-simmering maritime feud between China and Japan, and a
newer, fresher conflict that seems to be emerging with the developed
world over high-tech employment.

Beijing's use of its rare earths as a diplomatic cudgel was an
absurdly flawed tactic, but it brings this new conflict into clearer
definition. China's true challenge to the West—indeed, its winning
strategy—can be found in its ambitious modernization goals this coming
decade. Set out in obscure committee directives and benign national
policy choices, these are its best-laid plans.

The following incident, unrelated to the embargo firestorm, is
instructive on this larger issue. On October 19, one day after an
important Chinese Communist Party plenary session had meted out the
nation's trajectory for the next five years, a leak from the Ministry of
Commerce indicated that export quotas for rare earth elements (REEs)
would be 30 percent lower in 2011. The Ministry report also mentioned that exports might be outlawed entirely in the coming decade.

How this outlawing of exports (or even the quotas themselves) squares
with the WTO precepts signed by Beijing in its 2000 accession agreement
was not discussed. Because China controls 95 percent of all REE
mining, the ban would hit Western manufacturers hard. The story was
picked up by the Associated Press. The leak was then immediately denied
the next day, but the fact that it emerged the day after the United
States launched a probe into Chinese subsidies of its green industry and
following a pivotal CCP meeting on future energy security is suggestive.

Indeed, such a reduction doesn't deviate from the trend: Foreign
exports have been tightening for seven years. China in July slashed its
late 2010 export quota by 72 percent, arguing the country needs to
protect its supplies for the future. Shipments would be capped at 8,000
metric tons, down from nearly 28,500 tons for the same period in 2009.
As the state-sponsored People's Dailymade clear
in discussing the leaked report: "No one is entitled to criticize
China over this because this is an affair absolutely within China's
sovereignty."

Long the topic of metal speculators, the rare earths issue has
received copious press lately precisely because it intersects so many of
the great debates, anxieties, and aspirations of our time. As Beijing
seeks to cut off the world with a series of stringent quotas, those
cherished notions about free trade and an employment-enhancing "green
economy" are facing the tough reality of mercantilism, sourcing
monopolies, and an obscure world of technology metals that are rather
hard to mine cleanly.

There is a growing recognition that an emerging China might not
simply need a dignified "place at the table" and then always be a
progressive player on global agendas. In fact, as I wrote
earlier this year, China might behave more like the United States—a
hungry, solipsistic nation, capable of fierce unilateralist tendencies.

Threading through various PRC policy discussions and governmental
white papers, a general consensus appears: The next decade offers China a
historic "window of opportunity" to focus on solving its big domestic
needs while also lifting the nation to technological parity with the
West. Beijing's obsession with its own modernization will likely shock
the developed world in the coming years, as all calls for free trade and
"fair play" are met with indifference or suspicion.

The recent rare earth embargoes of Japan and United States appear to confirm this point.

The "Informal" Embargo

The world certainly got a bit less "Friedman flat"
last month when Beijing swung to hot, coercive diplomacy following the
September 7 arrest of one of its fishing boat captains near the Senkaku
Islands.

Some flare up of nationalist sensitivities was to be expected, yet it
is still astonishing how quickly the crisis cascaded into every aspect
of Sino-Japanese relations. Following the arrest by the Japanese coast
guard, China canceled cultural exchanges, dropped tourism, and tabled
all energy plans. It arrested four Japanese nationals on trumped-up
spying charges. It spoke ominously of economic consequences, and within
a week all exports of rare earth elements to Japan mysteriously ceased.
Ordered by Chinese customs officials, this "informal" embargo of
neodymium and other metals aimed to wobble the Nikkei's high-tech
manufacturers.

Faced with questions at a conference on October 3, Wen Jiabao pointed
to the overzealous patriotism of individual exporters and declared that
shipments would quickly resume. But they did not.

Indeed, the unspoken halt to all shipments spread to other developed markets within two weeks. On October 19, the New York Timesreported
that Chinese customs officials imposed restrictions on REEs bound for
the United States and Europe hours after a top Chinese official
denounced an American probe into Chinese subsidies. The restrictions
are explained now as a policy of heightened diligence. As Chinese
embassy spokesperson Wang Baodong described in a recent email:

With stricter export mechanism gradually in place,
outbound shipments to other countries might understandably begin to feel
the effect. But I don't see any link between China's reasonable rare
earth export control policy and the irrational U.S. decision of
protectionist nature to investigate China's clean energy industries.

Despite Wen's comments on October 3, the Japanese embargo stayed in
place for 26 more days, ending without any official acknowledgment on
October 29. Shipments to the United States and Europe also resumed that
day.

Whereas the developed world saw these trade bans as retaliatory,
Beijing soon presented them as a healthy approach to smuggling problems
amid necessary industry consolidation. The argument was that many of the
exporters had simply exhausted their quotas for the year and that the
lax environmental regulation that had allowed for pell-mell increases in
mining had to be curbed.

Ultimately both sides are right. The bans were clearly retaliatory;
China is concerned about its supply. But the rift in perspectives on
the issue suggests a new era may be taking shape: a bumpy
"deglobalizing" period when the developed world must question the wisdom
of trade dependence on China and cope with its inward focus.

Grand Plans for a Green China

The October CCP plenary session hammered out an ambitious plan. It
offers up a tough new energy agenda for the country, with a 15–20
percent reduction in energy intensity over five years and a 40–45
percent reduction in carbon emissions by 2020. It is a plan that can
only be met with a massive investment in "green" technology, which now
often depends on rare earth elements.

Rare earth metals are used extensively in the latest wind turbines
and electric cars. Traditional wind turbines have gearboxes that are
prone to break down. The new neodymium-iron-boron magnet generators have
far fewer moving parts and are therefore less costly to service in
extreme offshore locations. They are quickly becoming the turbine of
choice.

Similarly, each Toyota Prius hybrid uses 1 kilogram of neodymium in
its electric motor magnets, and about 10 kilograms of lanthanum in its
batteries. Those amounts will only go up as the car's power train
evolves for more efficiency.

Credit: Sean Daly (CC)

Earlier this year, China declared a national goal of reaching an
annual production rate of 1 million electric cars. Metals expert Jack
Lifton estimates
that this feat will require a staggering 1,000 metric tons of lanthanum
per year. Beijing is also aiming for 330 GW of wind turbine energy by
2020. Lifton suggests that this ten-year project will absorb some
59,000 metric tons of neodymium, 1,000 tons of terbium, and 3,000 tons
of dysprosium.

Producing all those green products is going to require a lot of rare earths.

The "Win-Win" Scenario

How will China maintain decent prices for the domestic companies it
has tapped to build its green future? It will control prices, curb
exports, and combat illegal mining. On July 10, 2010, China's Ministry
of Commerce declared full state intervention in the industry:

All REE prices will be set by the central government, with a national price set each month.

All REE mining companies will be consolidated by the state into 3–5 conglomerates.

Exports for 2010 were to drop to 40 percent of 2009 levels.

Prices spiked for all rare earths following this action, with
neodymium outside of China quadrupling to $80,000 per ton. It sells at
half that inside the country.

On October 18, the Secretary General of the Chinese rare earths
industry association suggested that in-China use will soar from 75,000
tons per year today to 130,000 tons in five years. This is why foreign
exports may be reduced further and—denials aside—exports of the "rarer"
rare earth elements might be outlawed altogether.

Developed countries were already squirming under recent Chinese
development strategies. Beijing started to reduce export quotas as
early as 2003. Though actual Chinese REE production climbed 60 percent
from 2003 to 2008, its exports to other countries during that period
dropped 50 percent.

Credit: Sean Daly (CC)

Why reduce exports,
especially when they fetch higher prices for the miners? China appears
to be implementing a nationalist agenda that does several things
simultaneously. By pressuring foreign companies to relocate factories,
with lower in-China sourcing costs as the lure, Beijing hopes to absorb
innovation and expand into those attractive industries. The move also
strengthens China's high-tech "national champions," which can produce at
even lower input costs than their Asian neighbors and mop up domestic
demand. China thus leverages its REE monopoly to climb up the
manufacturing chain, creating the magnets and value-added technologies
that require rare earths.

These "national champions" in the green and high-tech fields will
enhance employment at home, and their products will reduce pollution and
energy usage within China. They will also sell well in emerging
economies, further marginalizing the developed world's high-tech
manufacturers. The strategy produces a "guided market" virtuous circle.

The End of an Era

So how should the developed world react to reduced exports? These
new controls will draw down existing stockpiles and ultimately affect
high-tech pricing. According to Dudley Kingsnorth, executive director of Industrial Minerals Company of Australia:

First, the quotas are less than "rest of the world"
demand this year, which I did not believe would occur until 2011. …
Second, if this trend continues, world supply will not be able to meet
the shortfall for several years. In the near future, the shortfall will
be met by a drawdown of stockpiles.

Prices are already up significantly this year for most rare earths.
Lanthanum has doubled since July following China's intervention. The
price of dysprosium in China has gone from $50 per kilogram in 2005 to
$290 per kilogram this October, with that number often double outside
the country.

The West is being asked to source its own rare earths. But it might
not yet understand just how much higher those prices will go, having
historically experienced a pricing environment that can only be
understood as an anomaly. In a recent report,
the strategic consultancy firm STRATFOR analyzed the pricing of rare
earths over the past three decades and concluded that the West has been
quite oblivious to how abnormally cheap the metals were during the last
20 years due to China's unregulated mining.

Yes, total disregard for occupational safety and environmental impact
allowed for low-cost REEs worldwide. Pictures of Baotou miners often
show them caked in mud laced with thorium and uranium.

But the STRATFOR report makes another very interesting point, one
rarely discussed. It suggests that Chinese state loans to mining
operations—which were focused on "social stability through full
employment" and not profitability—gave the world decades of supply:

The REE industry—like many other heavy or extractive
industries—was targeted with massive levels of subsidized loans in the
mid-1980s. … Production rates increased by an annual average of 40
percent in the 1980s. They doubled in the first half of the 1990s, and
then doubled again with a big increase in output just as the world
tipped into recession in 2000.

World prices predictably plunged, by an average of 95 percent
compared to their pre-China averages. The consultancy firm computes
that if world prices were to go back to 1980s levels (and a non-Chinese
supply), the developed world would be seeing a vastly different cost
structure for many now pervasive products—including computer drives,
compact fluorescent bulbs, even those Apple earphones.

Take, for example, the Toyota Prius battery system. Its rare earths
components were responsible for a mere 0.9 percent of the car's cost in
2009. That percentage has increased to 2.9 percent due to higher
lanthanum costs this year, and that cost would increase further still to
15.2 percent if pre-China prices were applied.

Manage and Control

Last week, in a sign of growing concern, a collection of 35 business
groups from the United States, Europe, and Asia sent an open letter
asking officials at the G-20 meeting in Seoul to try to resolve the
issue of rare earths exports and their free trade. Unfortunately, it is
unclear what kind of real leverage over Beijing there is on this issue.
Tellingly, on the same day, the chemical giant W. R. Grace bid to
secure non-Chinese supplies. It tapped a new U.S. miner ramping up
initial processing in California, promising to buy 75 percent of all
lanthanum produced.

At the Asia-Europe Summit in Brussels last month, Wen Jiabao made a statement
on rare earths: "What we are pursuing is the sustainable development of
rare earths, which is necessary to meet our national needs—and also the
needs of the world." Wen, a trained geologist, went on to say that it
was "necessary" to "manage and control" the rare earths market.

About the Author: Sean Daly is an analyst and development consultant based in New York. He has written extensively on Asian economic development, exploring issues as diverse as Chinese urbanization, CMI multilateral currency swap arrangements, energy geopolitics in Kazakhstan, and Singapore’s high-tech water industry. He was educated at Columbia University and NYU and was a visiting lecturer at Princeton University from 2006 to 2009. His equity approach is to chart the broader demographic issues of globalization and find sectors, companies, or resources that are likely to benefit from emerging macro-trends. Opportunities are further refined through fundamental analysis and some basic quantitative techniques. Technical indicators are used exhaustively to determine tactical entry or exit points.